Letters of credit are legal instruments providing a financial guarantee. They assure a beneficiary that payments will be made or nonfinancial obligations performed by a seller or provider. Standby letters of credit are essentially fail-safe devices: If the purchaser doesn't fulfill the terms of the contract, the beneficiary can activate the standby letter of credit, which then provides compensation.

A Standby Letter of Credit Example

Say a company underwrites $500,000 of insurance written by Lloyd's of London. Instead of requiring the underwriter to deposit funds at Lloyd's, the company accepts a bank-issued standby letter of credit. The bank charges the underwriter for the guarantee and requires her to either keep funds equaling the amount of insurance underwritten on deposit or to give the bank unconditional control over her stock account with equivalent or greater assets. If the underwritten policies suffer losses that the underwriter fails to repay, Lloyd's demands payment from the bank, which then liquidates that amount from the underwriter's stock account.

Irrevocable Nature of Standby Letters of Credit

An essential characteristic of a standby letter of credit is that it is irrevocable, making it functionally nearly the same as cash. Once issued, the buyer cannot revoke it except in the rare instance of fraud that's proved in court. The irrevocability of the standby letter of credit is what makes it a powerful financial instrument that allows the purchaser to benefit from the use of funds that the bank guarantees the beneficiary will receive upon a later contingent demand.

Financial Standby Letters of Credit

Standby letters of credit are either financial standby letters of credit or performance standby letters of credit. Financial standby letters of credit are irrevocable undertakings by a bank guaranteeing the beneficiary repayment of the purchaser's financial obligation. The bank's guarantee that it will pay an underwriter's obligation to repay Lloyd's for insurance losses is a financial standby letter of credit. All financial standby letters of credit have a 100 percent conversion factor. Whatever is owed is paid in full.

Performance Standby Letters of Credit

Performance standby letters of credit are irrevocable undertakings by a bank to make a payment to the beneficiary in the event that the purchaser fails to perform a nonfinancial contractual obligation. These are considered "transaction-related contingencies" that are converted at 50 percent of the total transaction amount. In practice, performance guarantees often have a stipulated obligation on the face of the standby letter of credit. Performance standby letters of credit, for example, may be issued to a developer to guarantee a contractor's satisfactory fulfillment of a construction contract. A Federal Reserve letter notes that most standby letters of credit are financial, rather than performance, letters of credit. If, for example, the purchaser guarantees the beneficiary to perform some service or to pay a financial penalty for failure to perform, the fact that there is a financial penalty makes it a financial, rather than performance, standby letter of credit, even though the deficient performance triggers the demand

About the Author

Patrick Gleeson received a doctorate in 18th century English literature at the University of Washington. He served as a professor of English at the University of Victoria and was head of freshman English at San Francisco State University. Gleeson is the director of technical publications for McClarie Group and manages an investment fund. He is a Registered Investment Advisor.